Asymmetric correlations on the Croatian equity market

Davor Kunovac, Croatian National Bank, Zagreb, Croatia

AbstractThis paper compares the equity market in Croatia in bad (bear or turbulent) and good (bull, calm) market conditions. The two market regimes are formally identified under the Markov Regime Switching (MRS) framework. The analysis conducted suggests that correlations between equity prices are more than twice as high during bear than in bull markets. This result holds both for the shares included in the CROBEX and for the relationship among various European equity indices. In the context of international diversifi cation the result suggests only a limited benefi t that foreign investors can count on when diversifying their portfolios by expanding to developing European markets. In addition, by evaluating a portfolio optimization model that takes asymmetric correlations into account in an out-of-sample exercise, this paper also illustrates the losses that may occur if the asymmetry is ignored in practice.